The Sweet Spot: Your Best Combination of Points and Mortgage Interest Rates

When you shop for a mortgage, you’ll find that lenders offer you several combinations of price and rate to choose from. You might see something like this for a 30-year fixed loan:

5.000% with 1.000% points

4.875% with 1.375% points

4.750% with 2.000% points

4.500% with 4.500% points

5.250% with 0.000% points

5.500% with (1.000%) points

Which is your best combination? At one extreme, you have a 4.5 percent cost, and at the other, you have a 1.0 percent rebate. You can look at this puzzle in several ways.

Payback

Payback is a simple formula – how long does it take the difference in payment (your savings each month) to make up the additional cost of the mortgage? The difference in monthly payment is based on the loan that costs $0. Here’s what the payback on a $200,000 mortgage looks like:

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The first option has the highest payment, but it also gets you a rebate of $2,000. It would take over five years for the difference in payment to eat up the rebate, so if you don’t plan to own the house (or keep the loan) longer than five years, the loan with the highest rate and payment is probably the better deal. And the loan with the “best” rate? It would take eight years for the monthly savings to cover the upfront fees.

Note that this is a very simple formula, and it doesn’t account for the fact that you could earn income by investing the money not used to pay loan costs. Let’s say that you could earn 5.00% on your money. If you subtract the monthly investment income from the monthly savings, you lengthen the time it takes for the higher-cost loans to cover the upfront fees.

APR

Another way to compare loans with different rates and costs is by APR. Since lenders have to disclose the APR by law, this is probably the easiest method. APR, or annual percentage rate, incorporates the costs of the financing as well as the interest paid. Here are the APRs for each of these loans:

In this case, the most expensive loan has the lowest APR. Keep in mind, however, that these APRs only apply if you keep the loan for its entire 30 year term. If you don’t, the upfront costs of the loans are spread out over a shorter period, increasing the APR. Here’s what happens to APRs when you pay the loan over 15 years instead of 30:

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In this case, the loan with the lowest rate becomes the most expensive choice. In general, when you don’t expect to keep your home (or your mortgage) for more than a few years, it’s cheaper to choose the one with the fewest upfront costs.